Fossil fuel shocks and low carbon economy July 2011

A proposal prepared for the Department of Energy and Climate Change Contents

Executive Summary...... 1

1 Introduction ...... 2

2 Project Objectives & Approach ...... 3 2.1 Overview ...... 3 2.2 Modelling approach ...... 3 2.2.1 UK Energy Industry Model (UKEIM) ...... 4 2.2.2 UK model in the Oxford Global ...... 5

3 Project Deliverables ...... 7

4 Project Team & Management ...... 8 4.1 Key team members ...... 8 4.2 Project Management ...... 10

5 Oxford ’ Relevant Experience and Referees ...... 11

6 Project Terms ...... 13

APPENDIX A: About Oxford Economics ...... 14

A proposal prepared for DECC July 2011

Executive Summary

Energy have been trending up over the past decade and have also seen increased volatility in recent years. High and volatile energy prices are damaging to oil-consuming countries such as the UK by eroding consumer purchasing power and potentially hitting the competitiveness of some sectors of the economy, as well as discouraging investment by increasing uncertainty. This proposal sets out suggestions for how Oxford Economics can support the Department for Energy and Climate Change in undertaking scenario analysis to assess the potential implications of carbon mitigation policies for the UK’s sensitivity to energy prices.

Oxford Economics is uniquely positioned to help the DECC accomplish this goal using its suite of models that cover the UK economy in detail. We have considerable experience in modelling the economic impact of developments in energy prices and policies to reduce carbon emissions, having undertaken detailed studies for the UK and US governments, the European Commission and a number of blue-chip multinationals.

The objective of this study is to identify the short- to medium-term vulnerability of the UK economy to developments in energy prices under alternative assumptions about its energy intensity. To make such an assessment, we need a model that identifies the long-run equilibrium impact of these policy instruments and another that has a rich and detailed representation of the short- to medium-term dynamic properties of the UK economy. Our approach is to:

 Use the Oxford Economics’ UK Energy Industry Model (UKEIM) to identify the impact on the UK in equilibrium. The UKEIM builds a ‘bottom-up’ picture of the UK economy by aggregating individual sectors. The UKEIM will provide the long-run impact on sectoral competitiveness, output, capital stock, employment, and energy use of alternative assumptions relating to energy use and global energy prices.

 Use the Oxford Global Economic Model (GEM), the most widely-used global model in the world, which includes a detailed model of the UK economy, to assess what those long-run changes might mean for the dynamic adjustment path of the UK economy. The output of the UK is then the dynamic impact on GDP, rates, employment, and other macro variables in the UK.

The main deliverables from this project will be a comprehensive report outlining the channels through which lower energy intensity may benefit the UK in the face of higher energy prices and presenting analysis of the drivers of the results for each of the scenarios, as well as a summary PowerPoint presentation.

The fee for this project is £52,500 + VAT. As set out in the terms of reference, we would deliver a draft final report in the week commencing 10 th October 2011 with a view to finalising the report by 28 th November. We would also agree with the DECC key milestones during the project at the kick-off meeting in the week commencing 8 th August.

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1 Introduction

This proposal sets out suggestions for how Oxford Economics can support the Department for Energy and Climate Change in undertaking scenario analysis to assess the potential implications of carbon mitigation policies for the UK’s sensitivity to energy prices. The proposal is organised as follows:

 Section 2 states our understanding of the project’s objectives and describes the models Oxford Economics will use for the scenario analysis.

 Section 3 describes the deliverables from this project.

 Backgrounds for the Oxford Economics’ team for this project are highlighted in Section 4.

 Examples of relevant experience are provided in section 5.

 Section 6 sets out the proposed project terms.

 Appendix A includes background information on Oxford Economics.

If you have any queries with regard this proposal please contact:

Adrian Cooper

CEO, Oxford Economics

T: +44 1865 268900

E: [email protected]

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2 Project Objectives & Approach

2.1 Overview

Energy prices have been trending up over the past decade and have also seen increased volatility in recent years; for example, oil prices surged to nearly $150 per barrel (pb) in mid-2008, before plummeting to under $40pb in early 2009, only to recover back above $100 pb in 2011. Most forecasters now expect oil prices to remain around $100pb compared with just under $30pb in the early part of the 2000s. Other energy prices have seen similar trends.

High and volatile energy prices are damaging to oil-consuming countries such as the UK by eroding consumer purchasing power and potentially hitting the competitiveness of some sectors of the economy, as well as discouraging investment by increasing uncertainty. One way of reducing the UK economy’s exposure to developments on energy markets is to reduce its dependence of fossil fuels either by reducing its energy intensity or increasing the use of renewable forms of energy – of both production and energy use by households. Underpinning the UK’s carbon mitigation strategies are policies aimed at reducing the consumption of fossil fuels and, the extent to which these strategies are successful, a consequence of these policies would be a reduction in the UK’s exposure to price developments in international energy markets.

The aim of this project is to enrich the discussion on the UK’s climate change policies by factoring in how these policies could improve the stability of the UK economy in the face of global energy price shocks. To contribute to this analysis, the project requires a set of scenarios that vary two key assumptions:

 Alternative energy price shocks

 Alternative trends in energy efficiency

By undertaking a set of scenarios that vary these assumptions, it will be possible to assess the degree to which improved energy efficiency in the UK reduces the economy’s vulnerability to developments in the global energy prices. The rest of this section sets out the modelling approach that Oxford Economics proposes for the scenario analysis.

2.2 Modelling approach

The objective of this study is to identify the short- to medium-term vulnerability of the UK economy to developments in energy prices under alternative assumptions about its energy intensity. To make such an assessment, we need a model that identifies the long-run equilibrium impact of these policy instruments and one that has a rich and detailed representation of the short- to medium-term dynamic properties of the UK economy. Our approach is to use the Oxford Economics’ UK Energy Industry Model (UKEIM) to identify the impact on the UK in equilibrium, and the Oxford Global Economic Model (GEM), the most widely used global model in the world, which includes a detailed model of

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the UK economy, to assess what those long-run changes might mean for the dynamic adjustment path of the UK economy.

The UKEIM builds a ‘bottom-up’ picture of the UK economy, by aggregating individual industrial sectors, while the GEM is a macro model without any such sectoral disaggregation. Changes in added or in energy prices at the whole economy level in the UKEIM reflect changes to those variables within each sector and shifts in the composition of output across the sectors. Our strategy is to take those changes from the UKEIM and impose them as constraints on the whole-economy levels of productive potential and energy prices in the context of the GEM. The UKEIM thus tells us how the long-run equilibrium changes in response to different policy instruments; the GEM tells us how the economy adjusts towards that new long-run equilibrium.

2.2.1 UK Energy Industry Model (UKEIM)

The UK Energy Industry Model (UKEIM) was initially developed for a project for the UK’s Department of Business Enterprise and Regulatory Reform (BERR) – the specific unit of which is now part of the Department of Energy and Climate Change (DECC) – and was also used to inform the analysis for the Energy White Paper in 2007. The UKEIM builds a ‘bottom-up’ picture of the UK economy, by aggregating the information from 30 separately identified industrial sectors. Changes in value added or in energy prices at the whole economy level reflect changes to those variables within each sector and shifts in the composition of output across the sectors. It models in detail the production process for 31 industrial and commercial sectors, including their supply chain linkages and energy dependency. Household energy demand, including domestic transport use, is modelled separately.

The UKEIM also captures the way the economy shifts towards its new equilibrium, but it is really a general equilibrium model. It assumes that, while the economy might operate away from its efficient equilibrium for short periods of time (for the length of a typical , for example), eventually it will converge on that efficient equilibrium.

Critically for this project, the UKEIM allows for an assessment of how changes in the price of energy – whether from global changes or as a result of government policies and regulations – impact on the amount, type and cost of energy used by companies and households. The impact of energy prices will depend crucially on the energy intensity of the sector. The change in a sector’s energy bill then impacts on the rest of the economy through demand and competitiveness channels: in so far as higher energy prices reduces households’ purchasing power, this reduces in the economy, while firms will try to pass on higher energy prices, which discourages demand by raising output prices and possibly eroding UK firms’ competitiveness. Figure 1 provides more details on UKEIM.

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Figure.1: Overview of the Oxford UK Energy Industry Model (UKEIM)

Energy Prices, including carbon tax/prices (by fuel type)

Other costs Energy Intensity (incl. labour costs) Energy Prices (by fuel type) faced by other sectors & countries Carbon emissions Total Costs Costs & Prices Energy demand in other sectors & countries Output Price

Households Output in other sectors Output/Employment & countries

The UKEIM will provide the long-run impact on sectoral competitiveness, output, capital stock, employment, and energy use of alternative assumptions relating to energy use and global energy prices. It will also provide some constraints that will be imposed on the UK Macroeconomic Model in order to assess the dynamic response of the UK economy to developments in international energy prices. The key variables to be copied over from the UKEIM to the UK Macroeconomic Model are the productive potential of the economy and the price implications of higher energy costs.

2.2.2 UK model in the Oxford Global Economic Model

The UK macroeconomic model is embedded in Oxford Economics’ Global Economic Model, which covers some 46 economies in detail and allows the implications of alternative global scenarios and policy developments to be readily analysed at both the macro and broad sectoral level in the UK. In the model, domestic and external demand are the key drivers of the UK economy in the short term. In terms of private demand, consumers’ expenditure is a function of incomes, wealth and real interest rates. Government expenditures are assumed to be a policy choice. Business investment is determined by the level of relative return on capital, but is mainly driven by an ‘accelerator’ mechanism – that is, higher output leads to greater investment – while residential investment is modelled in a similar way to consumption. Exports are a function of world demand, domestic capacity and competitiveness, while imports are determined by real domestic demand and competitiveness.

The key underpinning for the model for UK is that the long-run properties of the economy are determined on the supply side. Put simply, the long-run trend rate of growth of the economy depends on the growth in the population of working

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age, the speed with which the capital available to workers increases, and total factor productivity growth. While the government can use policy to drive output above its potential level in the short term, in the medium term such excessive spending will be self-defeating as it will put pressure on capacity and then inflation and imports. In this project, we will constrain the supply-side of the UK macroeconomic model to be consistent with the outputs of the UKEIM.

In the economy, output cycles around potential output. Domestic firms are assumed to set prices given output and the capital stock, but the labour market is imperfectly competitive. Firms in each sector bargain with workers over , but they get to choose the level of employment. High real wages – relative to productivity – results in higher in the long run, and if real wages are rigid then unemployment is persistently high.

Inflation depends on domestic and imported prices and prices are modelled as a mark-up cost, with the level of demand in the economy relative to capacity determining the mark-up ie excess demand will result in higher prices as firms increase margins. Energy prices are an input determinant of costs and the impact of higher energy prices will be brought in from the UKEIM.

The Bank of England adjusts interest rates in line with inflation and demand developments – the so-called Taylor Rule – while differentials with other countries are crucial for determining exchange rates.

The output of the UK Macroeconomic Model is then the dynamic impact on GDP, interest rates, employment, inflation and other macro variables in the UK.

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3 Project Deliverables

The main deliverables from this project will be:

 A comprehensive report outlining the channels through which lower energy intensity may benefit the UK in the face of higher energy prices and presenting analysis of the drivers of the results for each of the scenarios.

 A summary PowerPoint presentation.

 Spreadsheet output to 2050 covering annual projections for the key economic indicators for the UK such as GDP and its components, output by sector, inflation, unemployment, government revenues, interest rates and exchange rates.

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4 Project Team & Management

4.1 Key team members

Adrian Cooper will act as Project Director for this project and be responsible for ensuring the submissions to the DECC from Oxford Economics are of the requisite quality. Scott Livermore will be project manager and co-ordinate the day-to-day activities required for this project and the sequencing of tasks.

Adrian Cooper – Chief Executive Officer

Adrian Cooper is Managing Director of Oxford Economics. He is responsible for coordinating and managing Oxford Economics' world economic modelling and forecasting activities, and overseeing its team of . Adrian has also been responsible for overseeing Oxford Economics’ work for the DTI/BERR on modelling the impact of policies to reduce carbon emissions, as well as contributing to its other studies on energy policy.

Adrian was educated at the University of Bristol, England, where he gained a first class degree in Economics; and at the London School of Economics and Political Science, England, where he achieved a distinction in the M Sc in Economics and won the Ely Devons prize for outstanding performance in the degree examinations.

Adrian spent the first seven years of his career with HM Treasury, England, including two years as coordinator of the government's macroeconomic forecast.

Role: Adrian would act as overall Project Director, responsible for overseeing the work and resource allocation and providing advice and quality control.

Scott Livermore – Director of International Macroeconomic Forecasting Scott Livermore oversees the day-to-day running of Oxford Economics’ international macroeconomic forecasting services. This involves supervising Oxford Economics’ team of forecasters and taking a lead role in directing the outlook at a global level, while ensuring consistency between the individual country forecasts. Scott also takes a lead role in a number of Oxford’s consultancy projects. Recent consultancy projects that Scott has worked on include developing macroeconomic models for the governments of Azerbaijan and Egypt, and reviewing the BERR Energy Model.

After completing a degree in Philosophy, Politics and Economics at St. Edmund Hall, Oxford University and an M Sc in Economics at University College London, Scott joined Oxford Economic Forecasting in 1997. During his initial five years at Oxford Economic Forecasting, he worked as a country analyst for a number of European countries and participated in numerous consultancy projects for a variety of international organisations (including the , IMF and EC), governments and multinational companies using both Oxford Economics’ Global Macromodel and building specialised economic models. Scott rejoined Oxford Economics in 2005 as a senior after spending two years at the

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Ministry of Finance in the Slovak Republic, assisting in preparing the medium- term macroeconomic framework and developing the analytical capacity of the Ministry of Finance to prepare macroeconomic forecasts.

Role: Scott would be day-to-day project manager and would be the main contact with the DECC. He would also oversee the scenario analysis undertaken for this project and be responsible for drafting the final report.

Marie Diron – Head of European and MENA Macroeconomic Services

Marie is head of European Macro services at Oxford Economics. Marie coordinates the macroeconomic forecast for Europe and works on a wide range of consultancy projects involving scenario analysis and bespoke modelling. In particular, she has worked on a range of projects on energy demand modelling: Marie re-estimated the BERR energy demand model in 2008; she also worked on the Roadmap 2050 project that modelled energy demand and CO2 emissions in the EU. Marie is also responsible for Oxford Economics' forecasts of the German and French economies.

Prior to joining Oxford Economics, Marie worked for Brevan Howard, one of the largest European hedge funds. She advised the fund’s traders on economic and developments. Prior to that Marie worked at the European , where as a Principal Economist she took various roles in forecasting, economic research and monetary policy analysis. In particular, she developed a set of models for short-term forecasting and contributed to the ECB's macroeconomic projections. Marie's first position was with Oxford Economics (then OEF), where she worked for three years as an analyst on European countries. She was also involved in specialist model-building and consultancy projects and in OEF’s international industry . Marie holds an M Sc (Cambridge) in Economics and is a graduate from the Ecole Centrale Paris.

Role: Marie will take the lead in implementing the scenario analysis.

John Bulford – Economist

John Bulford is an economist within the Global division of Oxford Economics. He first joined Oxford Economics in 2008 as part of a 12- month internship programme, working on the underlying data systems and as an assistant economist. After his internship he returned to Brunel University where he achieved a first class degree in Economics (B Sc). His dissertation examined bond spreads between sovereign debt of Eurozone economies, focusing on the extent to which Eurozone membership reduces default risk premia. John rejoined the company in July 2010 as an economist, and is currently responsible for monitoring and forecasting the economies of Chile, UAE and the OPEC region. He has also been involved in improving the range of financial variables within the global model.

Role: John will assist with the detailed scenario analysis.

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4.2 Project Management

Regular and effective communication lies at the foundation of successful project management. We will agree a communication plan at the outset, with key milestones clearly identified along with means of communicating with all parties with a stake in the project within the DECC and Oxford Economics. As Project Director, Adrian Cooper will have the key responsibility of ensuring that DECC’s quality standards and timeline are met.

While we do not operate to an accredited quality assurance process, the quality of our work is the foundation of our reputation and our success as a commercial organisation. The strength of our client list is testimony to the high standards we maintain. Our quality assurance processes include the following steps:

 All reports prepared for clients are subject to in-house review by at least two senior economists.

 Use of electronic data feeds, where possible, to avoid the need to manually enter information, while data is double-checked when manual feeds cannot be avoided.

 We have an appropriate programming of spreadsheets and other manipulation packages to ensure calculations based on source data are accurate.

 We have an agreed system for handling data revisions and for adjusting historical data where necessary (eg because newly-released data sometimes only include revisions back to a certain date and implies a sharp ‘break’ in the series prior to then).

 Feedback from clients and published work is used to improve our standards in terms of techniques adopted and the presentation format of results.

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5 Oxford Economics’ Relevant Experience and Referees

Incorporated in the Oxford Model is a detailed model of the global oil market and we offer proven strength in independent and rigorous economic modelling of the energy sector. Recent relevant projects include:

 Assessment of the long-term impact (up to 2030) on oil prices and by region for the DECC of alternative global oil supply profiles and alternative levels of spare capacity. This study also assessed the impact under alternative assumptions relating to the sensitivity of energy demand to changes in energy prices.

 Regular scenario analysis for GDF Suez looking at the impact of alternative economic scenarios on the energy market, and in particular oil prices.

 Production of regular scenarios for the UK and world economies, examining a variety of upside and downside risks, for a range of clients including Royal Bank of Scotland, Bradford & Bingley and the Royal Mail , which regularly include an assessment of the impact of alternative oil prices.

 Recent analysis using the Oxford Model assessing how damaging high oil prices are for the global economy and how a downturn in China would affect global commodity prices.

 Development of a suite of models for the Middle East economies and oil market development for the US government .

 Development of models for oil demand by sector and fuel type and studies on the impact of oil on the emerging market economies for the OPEC Secretariat , Vienna.

 Detailed modelling for the US Department of Energy of the demand and supply of energy for over 40 economies, separately identifying oil, gas, coal, electricity and other primary fuels, and for the major economies analysing demand at a sectoral level. This model was then used in work for the DoE and the European Commission to analyse the impact of measures to reduce carbon emissions.

 Roadmap 2050 Oxford Economics developed a macroeconomic model that integrated MAC curves to estimate the economic implications of achieving the 80% reduction target in carbon emissions.

 Modelling of the economic impact of energy price and policy shocks on the UK economy for the DTI as part of the first stage of its Energy Review and reported in the May 2007 White Paper on Energy .

 A report for the DTI that models the impacts of a variety of climate- change policies on competitiveness at a detailed sectoral level across each of the 27 members of the EU.

 Research for the DTI on industry sector output growth and carbon emissions projections for sectors in the EU ETS (prepared in conjunction with

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the Carbon Consortium and Future Energy Solutions) to help determine sectoral carbon allowances within the National Allocation Plan.

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6 Project Terms

The fee for this project is £52,500 + VAT. We have also completed the price and delivery schedule (PF36) as part of this tender submission.

As set out in the invitation to tender, this project is due to kick-off in the week commencing 8 th August 2011 and to be completed by 28 th November. We propose the following intermediate steps that are consistent with the timetable outlined by DECC:

 W/C 8 th August – kick-off meeting

 W/C 22 nd August – OE to circulate a PowerPoint presentation summarising covering initial modelling results for two baseline scenarios and two climate- change scenarios to ensure that the modelling approach is consistent with expectations. We also propose a conference call to discuss these initial results.

 W/C 5 th September – OE to circulate a PowerPoint report presenting the baseline and climate-change (2020 reductions) scenarios and the project team meets with the DECC to discuss results.

 W/C 19 th September – OE circulates revised results that reflect DECC feedback.

 W/C 10 th October – draft final report covering all scenarios is circulated and meeting to discuss findings.

 W/C 31 st October – revised final report reflecting DECC’s comments and a full set of spreadsheets with scenario outputs circulated.

 28 th November – report completed

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APPENDIX A: About Oxford Economics

Oxford Economics - formerly Oxford Economic Forecasting - was founded in 1981 to provide independent forecasting and analysis tailored to the needs of economists and planners in government and business. It is now one of the world’s leading providers of economic analysis, advice and models, with over 500 clients including:

 International organisations , such as the World Bank, OPEC and the Asian Development Bank.

 Government departments in many countries, including HM Treasury in the UK; the US Office of Transnational Issues; Ministries of Finance in, for example, Saudi Arabia, Slovakia, Bulgaria, Azerbaijan, Turkey and Egypt; the Economic Development Board in Libya; and tourism boards in the EU, US, Abu Dhabi, Dubai and the Caribbean.

 Central banks around the world , ranging from the UK and Spain to Chile, Hong Kong, Korea and Thailand.

 A large number of multinational blue-chip companies across the whole industrial spectrum , including, for example, IBM, Intel, BP, Shell, Unilever, HSBC, Banco Santander, Swiss Re, DaimlerChrysler and Boeing.

Oxford Economics commands a high degree of professional and technical expertise, both in its own staff of over 70 professionals based in Oxford, London, Belfast, Paris, the UAE, Singapore and Philadelphia, and through its close links with Oxford University and a range of partner institutions in Europe and the US.

Oxford Economics’ services include:

 International macroeconomic, sectoral and regional forecasts – with country briefing reports covering 190 countries; detailed projections for 85 sectors; and forecasts for local areas throughout the EU and cities in Asia.

 Bespoke econometric modelling – building detailed forecasting and simulation models and training clients’ staff to use them to support budget planning and policy decision-making.

 Detailed market analysis - translating our economic forecasts into forecasts for market segments and providing advice on market opportunities.

 Briefings for ministers, senior officials and executives – both presentations and tailored written reports on key economic issues.

 Outsourced economics support – providing on-call advice, data, modeling, briefing and policy advice.

 Economic impact assessments – analysing the economic and social contribution of particular sectors, investment projects or tax proposals.

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The key framework in which Oxford Economics’ analysis is conducted is its own Global Econometric Model, which covers some 46 economies in detail and headline statistics for another 35 economies. This Model – which is unique among the commercial economic consultancies – provides a rigorous and consistent structure for analysis and forecasting, and allows the implications of alternative global scenarios and policy developments to be readily analysed at the macro, sectoral and regional level. It is provided with very powerful, user- friendly software which enables Oxford Economics’ clients to use its Global Model to generate their own forecasts and undertake detailed scenario and policy analysis.

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